Midyear Consumer Spending Outlook: Sustained Spending, Pickup in Sight

Economics Group Special Commentary Midyear Consumer Spending Outlook: Sustained Spending, Pickup in Sight Eugenio J. Alemán, Senior Economist eugenio.j.aleman@wellsfargo.com (74) 41-3273 Michael A. Brown, Economist michael.a.brown@wellsfargo.com (74) 41-3278 Executive Summary The story of the consumer sector over the past two years has been one of modest growth. Real consumption has grown at only 2.2 percent, on average, since the recession ended, a clear downshift from the 3. percent pace the U.S. economy experienced during the last expansion. While the reasons for the slower pace of consumer spending are numerous, the depth of the job losses combined with tighter credit conditions and erosion of household wealth were, and for some households remain, the key headwinds to consumer spending. Today, the story appears to be a bit different. With consumer confidence trending higher and home prices recovering heftily, we believe the consumer is in a slightly better position to contribute to economic growth in the coming quarters. However, the pace of improvement will remain below that of prior recoveries. We begin our midyear consumer spending outlook by taking a look back at the first half of this year and some of the emerging trends in consumer spending that we expect will be key factors in helping to sustain spending in the second half of the year and into 214. We then present our latest economic outlook for consumer spending, along with the upside and downside risks to our forecast. Our expectation is that the turnaround in a number of key consumer sector drivers will help maintain the post-recession average in real consumer spending through the first quarter of 214 before the effects of continued job and income growth help to support spending in the 2.5 percent range by the end of 214. Overview of Consumer Spending in the First Half of the Year Consumer spending in the first half of the year was a bit softer than that of last year. Real personal consumption averaged around 2. percent compared to an average of 2.4 percent in the first half of 212. The details behind the spending activity were a bit more promising. Durable goods spending rose 6. percent in the first two quarters, boosted by ongoing strength in automobile sales (Figure 1). Spending on nondurable goods climbed 2.3 percent, up from the 2. percent pace observed in the first half of 212. The one point of softness this year is in services spending; however, the details of the latest GDP release show that most of the downshift is tied to the nonprofit households as opposed to a downshift in individual household spending. The breadth of improvement within the consumer sector so far this year has been a key support to economic activity, even with much softer overall GDP growth. The support from the consumer sector comes even in light of several headwinds that households faced over the past six months. The year began with a series of tax policy changes in the wake of the fiscal cliff debates. The result was an increase in taxes for most Americans across a wide range of the income spectrum. Beginning in January, the 2 percent payroll tax cut was allowed to expire which, in turn, resulted in a marked slowdown in consumer confidence and retail sales. In essence, the most direct economic impact of the fiscal cliff resolution came from the expiration of the payroll tax cut. In addition, income taxes also rose for individuals making more than $4, and $45, for joint filers. These tax policy changes resulted in two events that shaped consumer income in the first half of the year. We believe the consumer is in a slightly better position to contribute to economic growth in the coming quarters. This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

Figure 1 Figure 2 Real Personal Consumption Expenditures, Durables-4Q Moving Average Real Disposable Income vs. Real PCE 1 1 - - - - PCE-Durables: Q2 @ 7. - PCE-NonDurables: Q2 @ 1.7% PCE-Services: Q2 @. -1 2 22 24 26 28 21 212 - -1 - Real Personal Income Expenditure: Jul @ 1.7% Real Disposable Income: Jul @. 1 2 3 4 5 6 7 8 9 1 11 12 13 - Higher tax rates served as headwinds to consumer spending in the first half of the year. Source: U.S. Department of Commerce and Wells Fargo Securities, LLC First, the tax policy changes created a surge in fourth-quarter 212 real disposable income of 9 percent, which was almost completely reversed in the first quarter of 213, declining 7.9 percent as individuals realized dividend and capital gains income at the end of 212 to avoid higher 213 tax rates (Figure 2). Second, the reduced real disposable income resulted in consumers reducing their rate of savings to maintain their spending in light of the higher tax rate environment. The saving rate fell to 4.3 percent during the first half of 213 from 5.5 percent a year earlier. While higher tax rates served as headwinds to consumer spending in the first half, the past six months were also characterized by strengthening economic fundamentals. The pace of job growth continued to slowly pick up, inflation pressures began to ease a bit and consumer wealth and credit conditions continued to favor further spending growth. On the employment front, job growth averaged 197, per month in the first six months of this year, up from the 185, per month observed over the same period last year (Figure 3). More importantly, job growth has been broad-based across a number of categories which has helped to spur wage and salary growth. The income proxy, a combination of private sector average hourly earnings multiplied by hours worked, downshifted to start the year; however, in recent months income growth has begun to settle in the 2.5 to 3. percent range, indicating that the modest pace of income building continues. Figure 3 Figure 4 4 Average Monthly Employment Change Quarterly Average of Monthly Change, In Thousands 4 3. PCE Market Deflators 3. 2 2 2. 2. 2. 2. 1. 1. -4-4 1. 1. -6-6.. Average Monthly Change: Q2 @ 188 K -8 1 2 3 4 5 6 7 8 9 1 11 12 13-8 "Core" PCE Market Deflator: Jul @ 1.. 98 2 4 6 8 1 12. Source: U.S. Department of Labor, U.S. Department of Commerce and Wells Fargo Securities, LLC 2

Along with the slight acceleration in the pace of job gains, consumers also received help from easing price pressures in the first half of the year. Consumer prices rose a modest 1.6 percent in the first half of this year compared to the 2.4 percent year-over-year pace observed over the same time last year. The PCE deflator, another way in which to gauge consumer prices, increased 2. percent during the first half of 212 versus only 1.3 percent during the first half of 213 (Figure 4). If the deflator had performed similarly during the first half of this year, real consumer spending would have grown by close to 1.2 percent rather than nearly 1.9 percent. Even with continued gains in employment and income, consumers continue to face a number of challenges including reduced net worth and constrained credit conditions. Consumers net worth positions, while on the surface appear to be doing well, remain below their prerecession peak. The latest data from the Federal Reserve s flow of funds report show that the nominal level of household net worth has surpassed its prerecession peak as of the first quarter of this year (Figure 5). However a research note from the St. Louis Federal Reserve Bank published earlier this year points out that, after adjusting for inflation and population growth, household wealth remained far below its prerecession level as of the fourth quarter of 212. 1 After applying the inflation and population adjustments to the most recent data, real per capita household net wealth was just under $21,, still off the prerecession high of $234, (Figure 6). This partially explains why, even with a turnaround in home prices and equity market returns, consumers remain cautious. Figure 5 Figure 6 $8 Household Net Worth Trillions of Dollars $8 $26 Real Per Capita Household Net Worth Thousands of Dollars $26 Consumers continue to face a number of challenges including reduced net worth and constrained credit conditions. $75 $7 $75 $7 $24 $24 $65 $65 $22 $22 $6 $55 $6 $55 $2 $2 $5 $5 $18 $18 $45 $45 $4 $4 Net Worth: Q1 @ $7.3 Trillion $35 $35 1 2 3 4 5 6 7 8 9 1 11 12 13 $16 Real Per Capita Household Net Worth: Jan @ $29,556 $14 1 2 3 4 5 6 7 8 9 1 11 12 13 $16 $14 Source: Federal Reserve Board and Wells Fargo Securities, LLC Consumer credit conditions, while improving, also remain historically constrained. Nonrevolving credit, which is mostly student loans and auto loans, are still growing strongly but are down from the growth rates experienced in 21 when growth was close to 15 percent. Today, nonrevolving credit is expanding closer to 8 percent. Most lending activity remains closely tied to the automobile industry as longer duration loans and low rates have helped to maintain momentum behind the strong auto sales numbers over the past couple of years. 2 In fact, the rate on automobile loans was close to 7 percent at the end of the Great Recession as credit conditions remained tight. According to Federal Reserve data on consumer credit, the automobile loan rate was 4.98 percent in the first half of 212 and slid further in the first half of this year to 4.41 percent. The latest Quarterly Report on Household Debt and Credit published by the New 1 Gavin, W.T. (June 213). Household Wealth: Has It Recovered? Economic Synopses. 213 No. 16. Federal Reserve Bank of St. Louis. 2 For further details on auto lending trends see Alemán, E.J. and Brown, M.A. (April 213). What is Driving Auto Sales Higher? Wells Fargo Economics. 3

York Federal Reserve stated that auto loan originations rose to their highest level in Q2 since the third quarter of 27. 3 Revolving credit growth, which is mostly credit cards, has been more timid. Credit card lending is growing by about 1. percent on a year-over-year basis, but has remained very stable at that rate for more than two years (Figure 7). Thus, while helping a bit during the first half of the year, consumer credit continues to struggle especially credit card loans. In addition, the N.Y. Fed reports that indications of consumer credit demand remained flat as of the second quarter as consumers remained hesitant to utilize credit. 3 In addition, the level of household credit card debt continues to contract underscoring the reduced usage of new and existing credit cards (Figure 8). Figure 7 Figure 8 3 3 2 Consumer Credit Nonrevolving Credit: Jun @ 8. Revolving Credit: Jun @ 1.1% 3 3 2 4 4 3 3 Household Debt Mortgage: Q2 @ -3. Student Loans: Q2 @ 8. Credit Card: Q2 @ -. 4 4 3 3 2 2 2 2 1 1 2 1 2 1 - - - -1 - -1-1 81 83 85 87 89 91 93 95 97 99 1 3 5 7 9 11 13-1 - 4 5 6 7 8 9 1 11 12 13 - The key support for our outlook for real consumption growth hinges on continued job gains. Source: Federal Reserve Board, Federal Reserve Bank of New York and Wells Fargo Securities, LLC Firmer Consumer Spending Expectations Going into 214 With this year off to a slightly slower start for consumer spending, the next logical question is what will the consumer landscape look like in quarters ahead? Our outlook for the remainder of 213 maintains a moderate pace of real consumer spending growth through the year-end before gaining momentum toward the second half of 214. There are a number of key factors underpinning our forecast assumptions including our outlook for employment and personal income growth along with our expectation for continued improvement in consumer credit conditions. With job growth averaging in the 19, range for much of the second half of this year and our expectation for employment growth in the 21, range by the end of 214, the key support for our outlook for real consumption growth hinges on continued job gains (Figure 9). Job growth over the past few quarters has been more or less evenly distributed among both, above and below average paying jobs. 4 Barring a shift in the composition of job growth, wage and salary growth should continue to expand, helping to sustain personal income growth. In addition, we continue to expect the personal consumption deflator to run in the 1.3 percent range in the second half of the year, roughly in line with the rate over the past six months. Together, both of these factors should support further real disposable income growth in the 2.5 percent range over the second half of the year (Figure 1). 3 Federal Reserve Bank of New York. (August 213). Quarterly Report on Household Debt and Credit. Federal Reserve Bank of New York: Research and Statistics Group: Microeconomic Studies. 4 For further details see Bryson, J.H. and Watt, S. (Aug. 213). U.S. Job Growth and Average Wages. Wells Fargo Economics. 4

Figure 9 Figure 1 4 2 Nonfarm Employment Thousands of Employees, Average Monthly Change 4 2 1 Real Disposable Personal Income Bars = CAGR Line = Yr/Yr Percent Change 1 - - -4-4 -6 Nonfarm Employment: Q2 @ 187.7K -8 2 22 24 26 28 21 212 214-6 -8 - -1 Real Disp. Personal Inc. - CAGR: Q2 @ 3. Real Disp. Personal Inc. - Yr/Yr Percent Change: Q2 @.7% - 2 22 24 26 28 21 212 214 - -1 - Source: U.S. Department of Labor, U.S. Department of Commerce and Wells Fargo Securities, LLC In the coming months, retail sales are expected to post gains of around 4.5 percent through the end of the first quarter of 214. Retail sales should then slowly accelerate to around 5.6 percent by the end of 214 (Figure 11). We continue to expect headline retail sales to be primarily driven higher by auto sales. However, as was observed in July s retail sales report, broad-based gains in a number of product categories suggest that core consumer spending should also remain strong. That said, we do not expect a rapid acceleration in the overall pace of consumer spending. The latest research from the National Retail Federation continues to signal the high number of respondents reporting that they might be planning to spend slightly more this year but continue to look for ways to cut corners. 5 Thus, the more cyclical categories of eating and drinking places, clothing and electronics stores will likely continue to see only slight sales growth as consumers continue to maintain some caution in their spending habits. Figure 11 Figure 12 Bars = CAGR Retail Sales Line = Yr/Yr Percent Change Real Personal Consumption Expenditures Bars = CAGR Line = Yr/Yr Percent Change We continue to expect headline retail sales to be primarily driven higher by auto sales. 1 1 - -1 - -1 - - - - -2-2 - - -2 Retail Sales-CAGR: Q2 @ 3. Retail Sales-Yr/Yr: Q2 @ 4. -3 2 22 24 26 28 21 212 214-2 -3 PCE - CAGR: Q2 @ 1. PCE - Yr/Yr Percent Change: Q2 @ 1. - 2 22 24 26 28 21 212 214 - Source: U.S. Department of Commerce and Wells Fargo Securities, LLC After accounting for inflation, we believe that real consumption on the part of consumers will maintain its post-recession average of around 2 percent over the second half of this year and first part of 214. Assuming that economic fundamentals continue to improve, real spending should come in around 2.5 percent toward the end of our current forecast horizon (Figure 12). The key difference in the composition of personal spending, especially in the second half of 214, will be a modest pickup in the pace of services consumption. As the housing market continues to recover 5 National Retail Federation. (Jul. 213). Monthly Consumer Survey: Back to School 213. 5

Continued support from the consumer sector should also help to reinforce the pace of overall GDP growth. we expect further support to consumer spending through the consumption of housing-related services. Continued support from the consumer sector should also help to reinforce the pace of overall GDP growth. Our outlook for consumer spending, taken together with our outlook for GDP growth, implies that real consumer spending should account for 1.3 percent of GDP growth for 213, with even stronger support of 1.5 percent in 214. While the pace of improvement is moderate at best, it appears that a self-reinforcing recovery will continue in the consumer sector over the coming quarters. A discussion of our current outlook would not be complete without some mention of the downside and upside risks to our outlook. The primary downside risks to our outlook stem from domestic and geopolitical uncertainty. The upcoming debate over the future of federal spending could have implications for both job and income growth over our current forecast horizon depending on how Congress addresses the slated set of federal budget cuts known as sequestration. The recent tension in the Middle East has resulted in oil prices edging higher, which has the potential for creating greater inflation pressures than we are currently assuming. In addition, while interest rates remain historically low, the current rising interest rate environment poses a risk to consumer s ability to refinance existing credit and utilize new credit. All of these risks could adversely affect the pace by which consumers are able to spend in the near term. On the upside, the stronger-than-expected consumer confidence reading in August and consumers expectations for income growth over the next six months, if sustained, could provide a further boost to spending over our current expectations. The other main upside risk would be from stronger-than-anticipated job gains stemming from a stronger rebound in state and local government hiring and stronger healthcare hiring ahead of the affordable care act implantation in 214. While we continue to underweight both of these factors in our current thinking, the potential does exist for more robust consumer spending activity. 6

Wells Fargo Securities, LLC Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (74) 41-181 (212) 214-57 diane.schumaker@wellsfargo.com John E. Silvia, Ph.D. Chief Economist (74) 41-3275 john.silvia@wellsfargo.com Mark Vitner Senior Economist (74) 41-3277 mark.vitner@wellsfargo.com Jay Bryson, Ph.D. Global Economist (74) 41-3274 jay.bryson@wellsfargo.com Sam Bullard Senior Economist (74) 41-328 sam.bullard@wellsfargo.com Nick Bennenbroek Currency Strategist (212) 214-5636 nicholas.bennenbroek@wellsfargo.com Eugenio Aleman, Ph.D. Senior Economist (74) 41-3273 eugenio.j.aleman@wellsfargo.com Anika Khan Senior Economist (74) 41-3271 anika.khan@wellsfargo.com Azhar Iqbal Econometrician (74) 41-327 azhar.iqbal@wellsfargo.com Tim Quinlan Economist (74) 41-3283 tim.quinlan@wellsfargo.com Michael A. Brown Economist (74) 41-3278 michael.a.brown@wellsfargo.com Sarah Watt Economist (74) 41-3282 sarah.watt@wellsfargo.com Michael T. Wolf Economist (74) 41-3286 michael.t.wolf@wellsfargo.com Sara Silverman Economic Analyst (74) 41-3281 sara.silverman@wellsfargo.com Zachary Griffiths Economic Analyst (74) 41-3284 zachary.griffiths@wellsfargo.com Peg Gavin Executive Assistant (74) 41-3279 peg.gavin@wellsfargo.com Cyndi Burris Administrative Assistant (74) 41-3272 cyndi.burris@wellsfargo.com Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Advisors, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. ("WFS") is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. ("WFBNA") is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. WFS and WFBNA are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company 213 Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Services Authority. The content of this report has been approved by WFSIL a regulated person under the Act. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive 27. The FSA rules made under the Financial Services and Markets Act 2 for the protection of retail clients will therefore not apply, not will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE